Sunday, August 12, 2007

The most common ploy, inflating a borrower's income, accounts for 25% of all incidents of mortgage fraud, according to Fannie Mae. Fraud like this has been made easier by the emergence of a new breed of mortgages called "stated-income" loans, in which borrowers merely sign papers certifying their income, with banks verifying only the source of that income, not the amount. These risky loans carry greater interest rates—and therefore higher potential profits for the banks that underwrite them.

No. The "higher profits" do not come in because of a rate add-on for the stated income feature. First, the rate adjustment for stated income is supposed to be a matter of "risk-adjusted return" or risk-based pricing. In other words, the theory, at least, is that the increased probability of default on these loans makes up for that higher yield. The practical reality is that in the overwhelming majority of these cases the rate adjustment was ludicrously low. It was typical there in the boom years to see an adjustment of 0.25-0.50 in points for Alt-A stated. If you don't pay points in cash, that adds less than 0.125% to your note rate. The "higher profit" business was a simple question of making the loan or not making the loan. Verify income, no loan, therefore no profit of any kind; inflate stated income, make loan, make profit.

An observation about this part:

Elouise Manuel's story shows how shaky stated-income loans can be even if the lender doesn't commit fraud. In March, 2004, Manuel, a 67-year-old retired cafeteria worker from Atlanta, applied for a $25,000 loan to pay off some credit-card debt and other bills. She says she gave her independent mortgage broker, a relative, proof of her income and its source. But loan documents show that her monthly income was reported to be $1,100, more than twice the real amount. A letter from the Social Security Administration served as backup documentation, but the amount of income had been blacked out. A conditional loan approval letter from her lender, Pasadena (Calif.)-based IndyMac Bancorp Inc. (IMB ), notes: "Need [Social Security] benefit letters for last two years with income blacked out." Now Manuel says she can afford to pay only the interest on her loan, $210 a month.

IndyMac says it followed standard procedure to document the source of Manuel's income and adds it is not policy to verify the amount of income in that type of loan. It relies on the broker and the applicant, who signs the document, as Manuel did, to submit accurate information. IndyMac also says it believes Manuel is better off now because the payments on her loan are lower than those on her previous bills. IndyMac remains open to restructuring the loan—an offer it says Manuel's lawyer has rejected. As for IndyMac's direction to black out the income, company spokesman Grove Nichols says it was the action of an individual underwriter and not company practice: "It was an error of judgement." BusinessWeek could not identify the employee. Multiple calls to Manuel's brokerage firm were not returned.

A whole lot of lenders must have been employing that same rogue underwriter, because your Tanta has seen "blacked out docs" all over the place. This stems from the essential incoherence of "stated income" loans: the lender claims to verify the source of income but not its amount. For wage earners, one can call the HR department and get a "verbal verification" that the borrower works there. For self-employed borrowers, Social Security recipients, trust fund babies, day traders, and that special class of "real estate investors," you can't verify source of income with a phone call. So some enterprising lenders got the idea that a copy of a tax return or award letter would be used to verify source of income, but since it was a "stated" loan the borrower would black out the numbers, so lender and broker could pretend that they "didn't know" that something was a mite squirrelly here. (Since any innocent borrower will look at you like you just fell out of a tree if you ask for this, the broker just gets the doc and does the Sharpie trick him or herself, of course.) That whimpering you hear coming from the baseboards is the slow, pathetic death of the "stated income is for people who cannot easily provide us with documents" excuse.

But a first year law student's roommate's brother's kid the Cub Scout could probably tell you that asking for a blacked-out doc is a violation of rep and warranty on any known loan sale, such sales always including a general rep that the lender did not omit a material fact, and the verbiage of "known or should have known" tends to prevent anyone from claiming they had no idea that someone was trying to hide something. There are oh, so many repurchases underway (or completed, on the road to bankruptcy for the lender) involving those blacked-out docs. The borrowers' attorneys are now helping that repurchase become even more painful for the loan originator. Yours truly would like to see a small army of FDIC examiners rooting through loan files in search of those "conditional loan approvals," because it would be useful to know how many depositories that one rogue underwriter works for.